Naming Beneficiaries for Your Retirement Accounts: Getting it Right

By Liza Hanks
Liza Hanks

In Silicon Valley people have a tendency, either voluntarily or involuntarily, to bounce around through several different companies, if not careers, over a few decades. Many of my clients come to see me trailing a series of 401-k's from prior employers, or a three or four roll-over IRA's held at different companies. I always advise them to consolidate and simplify these fossil retirement accounts. For one thing, having many different accounts means extra fees. For another, it makes it difficult to even get a clear idea of their total retirement assets. And, lastly, having many different retirement accounts means many different opportunities to name the wrong people as beneficiaries to those accounts and makes the whole process of claiming those accounts after death much more difficult.

Though often treated as an afterthought, beneficiary designations really matter in estate planning (even though attorneys don't generally draft them). Many people don't realize that a Will or a trust has no bearing on how retirement assets are distributed and that instead, companies are legally obligated to distribute the plan assets only to the named beneficiary. One of the first things I do with new clients is to take a piece of paper, draw a line down the middle of it, and explain that they've got two entirely separate estate planning stories to tell: one governed by a Will or a trust and the other governed by beneficiary designations.

If you have multiple retirement accounts or questions about who to name as beneficiaries, here's a list of some important things to keep in mind.

At a minimum, I advise all my clients to review their existing beneficiary designations. Sometimes they'll discover that the 401-k from that first job still names a sibling, since it was opened before they got married. Other times, one child is named as a secondary beneficiary, but not the three who were born after that account was opened. Every once in awhile, we find a deceased spouse, or an ex-spouse named on an old account.

Anyone who has experienced any of these life events should definitely double check all of the beneficiary designations:

• Divorce
• Remarriage
• The birth of a child
• The birth of grandchildren
• The addition of step-children to the family
• Adding daughters-in-law or sons-in-law to the family
• The passing of other family members

It's almost always the right idea to name a spouse as the primary beneficiary of a retirement account. This is because spouses, unlike anyone else that a client can name, can defer withdrawals on those accounts until the spouse is 70 1/2 in most cases. This can result in years of income tax deferral before any required minimum distributions must be made.

And, unless children are minors, or are financially irresponsible, for most people, naming adult children directly as secondary beneficiaries is also the best choice. This is because doing so will give those children the most flexibility with respect to taking the money out of an inherited IRA slowly over their estimated life expectancy. This is called "stretch-out" planning.

A 52-year old who inherits an IRA from her deceased mother, can take required minimum distributions based on her life expectancy, and only pay income tax on those withdrawals as they are taken, leaving most of that account to continue to grow on a tax-deferred basis.

Sadly, while stretch-out planning makes the most tax sense, studies have shown that most beneficiaries do not take advantage of it -- instead they withdraw the entire amount, take the income tax hit, either immediately or over five years.

Until a child is 18, they cannot be named directly as a beneficiary of a retirement plan. If minor children are named directly, and the plan participant dies, before those retirement assets can be distributed to that minor, a property guardian must be appointed by the court. In most cases, there are two problems with this approach: the major one is that the property guardianship terminates when the child reaches age 18 (and that's long before most kids can responsibly manage money); a secondary one is that property guardianships can impose restricted investment conditions and can require the guardian to submit annual accountings to the court, which can be both expensive and inconvenient.

For parents with minor children, naming a living trust, or a trust created for the children under a Will, as a beneficiary is often the best choice, provided that the trust named has certain required provisions that will allow stretch-out planning for those minors. Naming a trust means that a Trustee can manage the assets for the child, and that the trust can last longer than only until a child turns 18.

A third option is to name an adult, as a custodian for that minor, under the California Uniform Transfer to Minors Act (CUTMA) to age 25. This is better than a court-appointed guardian, because it can last until a child turns 25 and requires no annual accountings to a court, and appropriate when someone doesn't have an existing Will or trust.

Naming charities as beneficiaries of a retirement account can be a smart tax move. A qualified charity will be able to withdraw retirement assets without paying any income tax and an estate can use the charitable deduction to the estate tax. Heirs can be left other assets that aren't subject to income tax. However, naming charities along with other beneficiaries on a retirement account must be done carefully. The rules governing stretch-out planning for inherited IRA's are complicated, and naming any charitable beneficiary can, if not handled right, result in requiring that the other, non-charitable beneficiaries withdraw the entire account balance within five years.

Filling out a beneficiary designation form, on its own, isn't that complicated. Unfortunately, there are plenty of traps for the unwary and rules that make it tricky for clients to accomplish their goals, even if the forms are filled out properly. If you have questions or concerns about how best to designate beneficiaries for their retirement assets, please feel free to contact me at lhanks@fmwlaw.com or call me at (650) 327-0088.